Fronting companies are facing challenges and greater scrutiny amid the recent Vesttoo scandal and Trisura matter with rating agencies and other stakeholders taking a closer look at the use of LOCs for reinsurance collateral. Following is an overview of the fronting market and what happened over the last several months to put this insurance model in the news.
Overview: Fronting Companies
Fronting companies serve as issuing insurance carriers, transferring the majority of premium and risk to reinsurers. They provide their financial strength rating, licensing, and other services primarily to managing general agents (MGAs). During the last five years, the fronting insurance space has grown from a premium size of about $4 billion to exceeding $12 billion, according to a report by Conning, a leading investment management firm with a long history of serving the insurance industry.
The expansion of the fronting market has been driven by a number of factors, including an influx of capital, MGA growth, positive rate trends, and increased acceptance of MGAs that use the fronting model. Moreover, according to Conning, access to large volumes of premiums afforded by this distribution route has attracted reinsurers that support these carriers.
The Emergence of the Hybrid Fronting Model
As more capital and new entrants entered the industry, various fronting strategies have emerged in the last several years, according to rating agency KBRA. Some companies retain no exposure while others retain a percentage of the risk on their balance sheet, which is what’s known as a hybrid fronting model.
A significant number of fronting carriers gravitated toward a risk retention model of 10%-20%, which reflects a combination of reinsurer demands for fronts to participate directly in the programs they cede to third parties and fronting carriers’ desire to capture a portion of the economics in the programs they underwrite.
Challenges Ahead
However, despite the growth in the fronting market, certain challenges have arisen, and the space is now at an inflection point as described in the Conning report. Significant increases in reinsurance rates indicate that fronting companies are likely to retain more risk. Furthermore, reinsurers are expected to be more skeptical of fronting company initiatives with no track record. Access to finance may also become a problem for some fronting organizations. As a result, it’s expected that consolidation among the 25 or so fronting markets will occur, according to Conning.
Then there is the fallout from the recent Vesttoo scandal in which fraudulent letters of credit (LOCs) were issued for reinsurance collateral. This follows what occurred with Canadian specialty company Trisura, which announced in February that its Q4 2022 results included an $81.5 million pretax write-down of a reinsurance recoverable related to a program in its U.S. fronting business.
Inside Vesttoo’s Fraudulent LOCs
Insurtech Vesttoo, via its digital platform, enabled insurance companies and MGAs to obtain reinsurance through the capital markets for traditional risks. In June, the Israeli company was investigated for allegedly issuing $4 billion in fraudulent or forged LOCs in reinsurance collateral.
Since then, Vesttoo has filed for Chapter 11 bankruptcy protection, fired several executives, and laid off half of its global workforce. In addition, an interim investigation revealed “pervasive and systemic misconduct was engaged in by a limited set of Vesttoo executives and other third parties outside of Vesttoo.” These individuals included Vesttoo’s former CEO, CFE, Senior Director/Capital Markets, and Senior Director/Asian Markets along with employees of China Construction Bank and Standard Chartered, which issued the fraudulent LOCs.
How Vesttoo’s LOC Fraud Impacted Fronting Companies, MGAs
On the heels of the Vesttoo scandal, carriers have scrambled to get the right collateral in place, either by replacing Vesttoo’s collateral certificates or by getting more funding to maintain their credit rating. Insurers across the market were fielding requests for replacement capacity to support the billions at risk, including from several fronting companies and some cedents and MGAs.
For example, fronting specialist Clear Blue, which had a significant relationship with Vesttoo, faced questions over the quality of its collateral, whether it exists at all or has any true value. As a result, within weeks, Clear Blue replaced more than half of the coverage needed for reinsurance programs affected by the collateral issues linked to Vesttoo.
According to Artemis, Tradesman Program Managers, a specialist MGA wholly owned by Roosevelt Road Capital Partners, secured replacement reinsurance cover for the section of its tower that had been provided through a Clear Blue fronted arrangement with Vesttoo.
MGA and insurance carrier hybrid Homeowners of America Insurance Company (HOA), a subsidiary of Porch Group, was also exposed to the Vesttoo LOC fraud and replaced some 84%, or $147 million, of reinsurance affected by the issues by early September. As a result of the Vesttoo fraud, HOA was placed under temporary regulatory supervision by the Texas Department of Insurance (TDI) and remains so today.
Vesttoo Scandal Puts the Spotlight on Fronting Sector’s ERM
According to KBRA, the Vesttoo case highlights the fronting sector’s enterprise risk management (ERM). KBRA “believes it’s increasingly important for fronts to maintain robust risk management processes and for management teams to be focused on continuous ERM improvement.” The rating agency provided areas for potential improvement in the fronting sector, including:
- Implementing more stringent diversification requirements for collateral providers
- Not binding policies until after LOCs have been verified
- Reducing the relative amount of exposure to LOCs and increasing the amount of collateral held in trust
- Reducing the portion of unrated and captive entities on reinsurance panels
KBRA noted that “recent negative events underscore the critical importance of effective enterprise risk management (ERM) and could be positive catalysts for change.”
What AM Best Had to Say About Vesttoo and Fronting Companies
AM Best also weighed in on managing counterparty risk amid the Vesttoo fraud fallout. The rating agency has been monitoring the Vesttoo situation and reviewing its rated fronting carriers, as well as other insurers that have material amounts of reinsurance counterparty credit risk and reliance on various forms of collateral.
Fitch Ratings Sees Possible Change with LOC Collateral
Fitch Ratings expects the impact from Vesttoo to be widespread and potentially long-lasting, perhaps triggering a change in how the industry operates regarding LOC collateral.
“The investigation on possibly forged collateral linked to reinsurance deals facilitated by insurance technology facilitator Vesttoo Ltd. may decrease the usage of letters of credit as collateral in the wider reinsurance market,” Fitch said.
“Fronting companies and managing general agents, whose business often relies on LOCs, may face lower available capacity and tighter terms.”
However, Fitch also indicated that this is an opportunity for some capacity or capital providers to come in and give efficient collateral to support MGA and fronting companies’ reinsurance needs, which we have already witnessed since the Vesttoo scandal came to light.
ALIRT Questions How Industry Stakeholders Missed Vesttoo’s Fraud
A white paper from ALIRT Insurance Research outlined its difficulty in understanding how different participants in the industry missed the alleged fraudulent LOC issue surrounding Vesttoo. According to ALIRT, all parties involved, from wholesale brokers and their reinsurance broker partners to the issuing insurers and their reinsurance counterparties, as well as Vesttoo, “bear some responsibility for this mishap.”
“While we concede that this was likely a well-designed fraud, it is difficult to fathom that it was able to evade multiple levels of due diligence purportedly carried out by these different participants. That is, unless corners were being cut in the race to place premium into difficult corners of a challenging P&C market,” reads the white paper.
ALIRT analyzes the relative financial performance of insurers on behalf of insurance distributors, insurers, institutional buyers, and analysts to satisfy their risk management, due diligence, and marketing and research needs.
Conclusion: What’s Next for the Fronting Market?
Most in the industry expect the fronting industry to be well positioned to learn lessons from the Vesttoo scandal and Trisura write-down and perhaps emerge as a stronger and more robust member of the broader insurance market. Improved ERM and due diligence will result in the wake of recent challenges.